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Balancing the Books

Dr. Doom's Old-Time Medicine

By

Jay Palmer

Updated Aug. 7, 2000 12:01 am ET / Original Sept. 15, 2019 9:21 am ET

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B efore the financial world hung on every word uttered by Alan Greenspan, Wall Street shuddered each time Henry Kaufman spoke. As the chief economist of Salomon Brothers, Kaufman's influence in the 'Seventies and early 'Eighties cannot be overstated. When Greenspan speaks of where the economy, inflation and interest rates are headed, we know that he, more than anyone, can influence the outcome. Kaufman, in contrast, had no such levers to pull, and yet would move markets more profoundly than the Federal Reserve chairmen of the time.

Today, Kaufman's impact on markets is barely perceptible. He is respected as an eminence grise , but it's been years since traders and investors would stampede on hearing his forecasts. Kaufman accurately assessed the forces that culminated in the financial maelstrom that resulted in double-digit inflation, steep recession and 20% interest rates by 1980. But he never came to grips with the change from the worst to the best of all possible economic and financial worlds.

That becomes evident in reading Kaufman's recently published autobiography, On Money and Markets . In recounting how he earned the sobriquet of Dr. Doom, it's evident that he blamed the sorry state of affairs of the 'Seventies on the breakdown in the 'Sixties of established rules and norms that had rigidly ordered the world of finance. Banks took deposits and made loans, insurance companies covered lives and property and made conservative investments, and Wall Street underwrote securities. Now all those functions are under a single corporate roof at Citigroup, among others.

Kaufman's acute discomfort with radical change might be traced to his childhood in Germany, from which he and his family fled to settle in New York City's Washington Heights. He recounts hearing tales about the Weimar hyperinflation, which helped pave the way for the Nazis to come to power. This made him sensitive to the threat of inflation (to which Americans were oblivious until it was out of control).

In recent years, Kaufman has warned incessantly of the risks associated with every financial innovation -- derivatives and junk bonds in particular. The latter, of course, lay at the core of the conflict that led to his departure from Salomon in the 'Eighties. Yet there is no sense of the benefits of these instruments: While derivatives can be instruments of feckless speculation, they also allow institutions to manage risk more efficiently. Junk bonds also funded many an entrepreneur who lacked an investment-grade pedigree. (The junk deals of the 'Eighties look positively gilt-edged compared to today's IPOs.)

The problem, as Kaufman sees it, is that just as war is too important to be left to the generals, the financial system is too important to be trusted to the markets. Financial stability is a political and social goal to be pursued. His warnings about growing risk have resonated among many observers who fret about the rampant speculation on the Nasdaq. He also argues cogently that mathematical models work only when markets function perfectly, as they usually do, but are useless when they don't -- as the Nobel laureates of LongTerm Capital Management learnt to their dismay when that huge hedge fund ran aground in 1998.

As Schumpeter famously showed, capitalism is a process of creative destruction. Capitalism without failure is like religion without sin. But there is redemption. Assets in bankrupt enterprises are redeployed in profitable ventures as unsound structures are replaced. In Korea, the chaebol are being dismantled, and the economy is more vibrant for it.

Kaufman mentions having read Hayek's The Road to Serfdom as an undergraduate, but clearly this seminal answer to the siren song of government intervention had little impact. The Austrians, such as Hayek and Mises, show that financial disequilibriums result primarily from central-bank credit expansions beyond savings -- a classic inflation. The reason Orange County came a cropper in 1994 owed less to the derivatives that Kaufman decries and more to the fact that the Greenspan Fed held the federal-funds rate at an unnaturally low 3%, which subsidized interest-rate speculation by dunderheads.

Now, a little more than a year after Greenspan -- along with former Treasury Secretary Robert Rubin and current Treasury head Lawrence Summers -- were being hailed as saviors of the world for reflating in the wake of the Russian default and the near-breakdown of LTCM, the results of these machinations are becoming more apparent. The massive expansion of liquidity to bail out feckless speculators fueled the Internet IPO boom, which now is becoming a bust. But the markets have come to expect a bailout from Greenspan and his fellow central bankers anytime the going gets rough. The moral hazard is manifest.

Kaufman wants to turn the calendar back to a time when risk seemed suppressed by custom and regulation. He recognizes this is impossible, so he proposes some ubermeister to maintain order and stability. If the Internet has demonstrated anything, it's that any institutional arrangement can be circumvented by the click of a mouse. Markets now more resemble the competitive models that once existed mainly in textbooks.

Kaufman is utterly correct that the current regulatory structure cannot cope with this new financial world. But institutions once considered too big to fail now may be too big to bail out. As long as markets expect governments to bail them out, the risk that Dr. Doom fears only increases.

Reviewed by Randall W. Forsyth

RANDALL W. FORSYTH is an assistant managing editor of Barron's.

Beyond Greed and Fear

P sychology continues to make inroads into finance. As such, the editor of the Financial Management Association Survey & Synthesis Series thought it fitting to include Hersh Shefrin's Beyond Greed and Fear in its collection. Behavioral finance provides a leading challenge to traditional finance (which encompasses the efficient markets hypothesis and capital asset pricing model, for example) by uncovering market inefficiencies and biases.

Shefrin's objective was to "provide a comprehensive treatment of behavioral finance for a practitioner audience" (institutional and individual investors alike) to force investors to recognize behavioral biases and inefficiencies in the financial markets. On that score, the Santa Clara University finance professor, who has contributed extensively to the academic literature in this area, succeeds in showing "what behavioral finance has to offer." Unfortunately, he also demonstrates why the application of the touchy-feely side of finance remains on the fringe.

The book is written in the style of an MBA-level text, which Shefrin uses in his own class, but the chapters draw heavily on stories from The Wall Street Journal and Barron's in hopes of using numerous anecdotes to expose a behavioral focus or bias in the market. The book's survey of recent academic literature is very good, which probably is the best reason to read it. However, some parts of the book are tedious and conceptually redundant, since Shefrin explores many of the same issues for a range of financial instruments -- stocks, bonds, mutual funds, forex, futures and options. Too frequently, the author's interpretations of investor anecdotes seemingly fall victim to the often-scorned overconfidence bias (that is, he is too sure of the behavioral mistakes).

A confusing point is in the chapter on picking stocks the behavioral way. Shefrin argues that even when investors recognize inefficiencies in the market, they still will find it difficult to capture profits from equity mispricings, which curiously led him to conclude that investors "would be better off acting as if ... markets are efficient." Huh?

Behavioral finance has captured the hearts and minds of more academics and practitioners, who are in search of an understanding and framework for how markets operate, especially in recent years when traditional valuation models and theories seemingly have failed to provide guidance. Hence, Shefrin's survey is timely, but he oversells its applicability.

Unfortunately, the investment insights from behavioral finance are disparate, which led University of Chicago Professor Eugene Fama (who developed the efficient markets hypothesis) to observe that behavioral-finance proponents "don't have a coherent theory, and without that, there is no behavioral finance." Peter Bernstein (in his book Against the Gods ) probably reflected a more balanced view of behavioral finance when he wrote, "While it is important to understand that the market doesn't work the way classical models think ... I don't know what you can do with that information to manage money."

Reviewed by Michael P. Niemira

MICHAEL P. NIEMIRA is a vice president and senior economist at the Bank of Tokyo-Mitsubishi in New York.

New & Notable

Welcome to the wild 'n' woolly world of the virtual bourse. Ride along as the author, a Wall Street Journal senior writer, probes the underbelly of the latest high-tech craze: Internet stock trading. In moving the trading game from Wall Street to Main Street, rogue players like Tokyo Joe, Bear Down, Big Dog and Floydie create their own frontiers and make their own rules -- and everything's up for grabs.

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